Grantor Retained Annuity Trust (GRAT)

Tax specialists are paying attention to how half a dozen of Facebook’s top names, including founder Mark Zuckerberg, appear to be using a perfectly legal maneuver called a grantor-retained annuity trust, or GRAT, to avoid at least $200 million of estate and gift taxes on their own Facebook shares.

A grantor retained annuity trust may be an effective means for a wealthy client who wants or needs to retain all or most of the income from a high-yielding and rapidly-appreciating property to transfer the property to a child or other person with minimal gift or estate tax. GRATs are particularly indicated where the client has one or more significant income-producing assets that he or she is willing to part with at some specified date in the future to save federal and state death taxes and probate costs, to obtain privacy on the transfer, and to protect the asset against the claims of creditors.

A GRAT is created by transferring one or more high-yield assets into an irrevocable trust and retaining the right to an annuity interest for a fixed term of years or for the shorter of fixed term or life. When the retention period ends, assets in the trust (including all appreciation) go to the named “remainder” beneficiary (ies). In some cases other interests, such as the right to have assets revert back to the transferor’s estate in the event of the transferor’s premature death, may be included.

Facebook’s prospectus cites eight separate “annuity trusts” set up by insiders Dustin Moskovitz, Parker, Sheryl, Reid Hoffman, Michelle Yee (Hoffman’s wife) and Zuckerberg over the past four years. All told, these trusts hold about 22 million shares that will be worth more than $690 million if Facebook goes public at $31.50 a share, the middle of its projected range.

GRATs provide a fixed annuity payment, usually expressed as a fixed percentage of the original value of the assets transferred in trust. For example, if $100,000 is placed in trust and the initial annuity payout rate is 6 percent, the trust would pay $6,000 each year, regardless of the value of the trust assets in subsequent years. If income earned on the trust assets is insufficient to cover the annuity amount, the payments will be made from principal. Therefore, the client-transferor is assured steady and consistent payments (at least until principal is exhausted).

All income and appreciation in excess of that required to pay the annuity accumulate for the benefit of the remainder beneficiary (ies). Consequently, it may be possible to transfer assets to the beneficiary (ies) when the trust terminates with values that far exceed their original values when transferred into the trust and, more importantly, that far exceed the gift tax value of the transferred assets.

Facebook offers a good vehicle for describing the inner working of GRATs to sidestep estate and gift taxes.

In essence, these trusts transfer asset appreciation from one taxpayer to others, virtually tax-free.

The benefit can be huge. If the Facebook insiders didn’t use GRATs for those shares, but held them until they died or gave them away to friends or relatives after the offering, then the gift or estate tax owed on the shares would be more than $200 million. (This calculation assumes a $31.50 share price and the current top gift- and estate-tax rate of 35%; rates are scheduled to rise to 55% next year.)

The gift tax value of the transferred assets is determined at the time the trust is created and funded using the “subtraction method.” The gift tax value is determined by subtracting the value of the annuity interest (and, in some cases, other retained interests, such as the right to have the assets revert back to the transferor’s estate if he or she does not live the entire term of the trust) from the fair market value of the assets transferred in trust. How the annuity interest and any other retained interests are valued depends on who the remainder beneficiary (ies) is (are) and who retains the annuity and other interests relative to the transferor. There is a more restrictive and less appealing set of valuation rules when family members are beneficiaries and certain family members retain interests in the property both before and after the trust is created than when unrelated parties are involved.

Here is an example, using figures from the Facebook offering document: Zuckerberg and Moskovitz each disclosed “annuity trusts” holding 3.4 million and 14.4 million Facebook shares, respectively. The value of each share when the trusts were set up was less than $1.85, according to the prospectus.

After contributing their stock to the GRATs, the two founders would, over time, take payments equal to the original value of the gift plus a small return. Without knowing information that’s unavailable-such has how long the trusts will run or exactly how they are structured-it’s impossible to say what payments have already been or will be made.

But it is possible make an educated guess as to the appreciation that’s being shifted from the two founders’ estates. Given a $31.50 share price, a conservative estimate of it is $29 per share, or about $100 million for Zuckerberg and more than $415 million for Moskovitz.

At current top rates of 35%, that means estate-and gift-tax savings of about $35 million for Zuckerberg and $150 million for Moskovitz. Other Facebook insiders and investors appear to be saving $20 million or more with their GRATs.

What if Facebook stock declines? The stock would then be returned to the original owner.

The person who sets up the GRAT is not really worse off, because he paid little or no tax in the first place. Either he wins or it’s a tie-except for the lawyer’s fees. The principal risk with a GRAT is that the owner will die before the term is up.

If family members are involved, the gift tax valuation rules of the Internal Revenue Code may apply. Under these rules, certain types of retained interests, such as the right to have trust assets revert to the transferor’s estate in the event of the transferor’s premature death, may be valued at zero when computing the gift tax value of the transfer. As a general rule, every retained interest but a “qualified interest” is assigned a value of zero for gift tax valuation purposes.

Since the GRAT permits payment of both income and trust principal to satisfy the annuity payments you have retained, the GRAT should be treated as a grantor trust for income tax purposes. This means you (the transferor-annuitant) are taxed on income and realized gains on trust assets even if these amounts are greater than the trust’s annuity payments. This further enhances this tool’s effectiveness as a family wealth-shifting and estate-tax-saving device. In essence you are effectively allowed to make gift tax-free gifts of the income taxes that are really attributable to assets backing the remainder beneficiary’s interest in the trust.

By making assumptions about income to be earned by the trust in the future, and future capital growth, it is also possible to project the future value of the principal remainder that will be payable to the beneficiaries at the end of the term of the trust. If limited partnership interests, minority stock interests, or other fractional or non-controlling interests have been contributed to the GRAT and appropriate discounts claimed for lack of voting power or lack of marketability, it may also be useful to illustrate the future economic growth of the pre-discounted value of the principal, and to compare the present value of the remainder for gift tax purposes (including appropriate discounts) with the projected future value of the principal remainder (without discounts).

A successful GRAT requires several ingredients: a person worth millions-or potential millions-who wants to avoid gift or estate tax and is willing to part with assets to do so; an asset that will rise in value while in the trust; and, if possible, low interest rates.

With these elements in place, the taxpayer sets up a GRAT with a set term of two years or longer and gives the asset to it before its value surges. Set-up costs include appraisal and legal fees.

Over the life of the trust, the person who set it up gets annual payments adding up to the asset’s original value plus a return based on a fixed interest rate determined by the Internal Revenue Service. That is currently 1.6%, near a record low.

Meanwhile, ideally, the asset soars in value, and that growth is outside of the grantor’s estate. When the GRAT’s term ends, the asset goes to the beneficiaries-usually into another trust set up for their benefit.

The result: no gift or estate tax on the appreciation, even though it has been transferred.

One question remains: neither Zuckerberg nor Moskovitz have children. So who are these trusts’ beneficiaries? It is possible to name unborn children-as well as future spouses and current friends or relatives-as beneficiaries of a GRAT.

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